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Why SEC Fined Wells Fargo $35M Over Inverse ETFs

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The Securities and Exchange Commission said in late February that Wells Fargo agreed to pay $35 million over shortcomings with its investment recommendation practices.

The regulator charged Wells Fargo Clearing Services and Wells Fargo Advisors Financial Network with failure to supervise and train investment advisors and registered representatives recommending single-inverse ETF investments to retail investors; it also said the bank lacked adequate compliance policies and procedures tied to the suitability of these recommendations.

Inverse exchange-traded funds use various derivatives to profit from a decline in the value of an underlying benchmark and/or to hedge a portfolio from a decline; they also are known as “short” or “bear” ETFs. Single-inverse ETFs, referred to as 1X (for “one times”) products, are 100% hedged vs. other products (2X and 3X), which are 200% and 300% hedged, respectively.

The latest settlement comes less than a week after Wells Fargo agreed to pay $3 billion to the SEC and Department of Justice to resolve potential criminal and civil charges tied to its fake-accounts scandals.

From April 2012 through September 2019, the bank’s policies and procedures “were not reasonably designed to prevent and detect unsuitable recommendations of single-inverse ETFs,” the SEC said in late February when it announced the settlement.

The regulator concluded that some Wells Fargo brokers and advisors didn’t “fully understand the risk of losses these complex products posed when held long term,” which led to some clients to buy and hold single-inverse ETFs for months or years. Plus, a number of the clients were senior citizens and retirees with limited incomes and net worth, and conservative or moderate risk tolerances.

“Firms must maintain effective compliance and supervisory programs to ensure that the securities they recommend are suitable for their clients,” said Antonia Chion, associate director of the SEC Enforcement Division. “As a result of Wells Fargo’s failure to meet these important obligations, some of its employees recommended complex instruments to retail investors who did not understand the risks involved.”

Without admitting or denying the findings, the bank agreed to pay a $35 million penalty and distribute the funds to some clients who were recommended to buy single-inverse ETFs and suffered losses after holding the positions for longer periods, according to the SEC.

Its order also censures Wells Fargo and requires it to cease and desist from committing or causing any future violations of the relevant provisions.

“Wells Fargo Advisors settled claims with the U.S. Securities and Exchange Commission related to our policies and procedures and supervision of single-inverse exchange-traded funds (‘single-inverse ETFs’). Wells Fargo Advisors no longer sells these products in the full-service brokerage,” the bank said in a statement.

Thematic Funds Are Hot. Should You Recommend Them?

Thematic funds may have grown dramatically in the past three years, to $195 billion in assets under management worldwide vs. $75 billion three years ago, but they’re still only 1% of total global equity fund assets, states Morningstar in a new study on these products.

Though 154 new thematic funds were launched in 2019 (down from 169 in 2018), there are only 923 of these funds in the Morningstar global database, according to the Global Thematic Funds Landscape report by Morningstar Director of Global ETF Research Ben Johnson, senior analyst Kenneth Lamont and analyst Daniel Sotiroff.

Of thematic funds launched prior to 2010, less than half still exist, while of the funds launched prior to 2015, 69% have survived. Only one in four outperformed the MSCI World Index over that 10-year period. And globally, fees are higher than non-thematic counterparts.

So exactly why have they exploded in growth, at least overseas?

“This is a space that is very cyclical,” Johnson told IA. “The growth tends to coincide with bull markets, so it’s not surprising that over the course the past five years, we’ve seen pretty significant growth given in large part because the market’s been very favorable.”

Defining Thematic Funds

The report defines thematic funds as those that “attempt to harness secular growth themes ranging from artificial intelligence to cannabis.” These funds are very focused, so sustainable funds may be included, such as those that capitalize on a transition to a low-carbon economy. However, those funds that are broader in scope, such as overall environmental, social and governance funds, are not.

Morningstar has broken the funds into four broad themes: Technology, physical world, social, and broad thematic, which then include specific areas.

For example, social includes consumer, demographics, security, wellness and politics. The demographic area, in turn, contains funds that focus on population aging and other demographic trends.

Where’s the Interest?

Thematic funds domiciled in Europe have the greatest share of the market, with 54% of assets, up from 2% in 2000. In contrast, the share of assets in funds domiciled in North America decreased to 16% from 28% over the same period (although in the last trailing five years all areas had had inflows).

Most of these funds are actively managed; however, in North America, 80% of the funds are passively managed, largely due to the success of ETFs, according to Johnson. The active management is one reason fees are higher, at least overseas. Further, each fund is different in its scope, Johnson says. “When you frame fees against those large performance differences, they don’t feel as egregious. It’s not a commoditized product like the next S&P 500 ETF.”

Technology thematic funds have the highest amount of assets, with $97.3 billion at the end of 2019. Within technology, robotics and automation have the largest share, with $27 billion in assets in that group.

Johnson adds that these thematic funds also can “spice up” some portfolios that have needed a boost, or provide “conversational alpha” in which the advisor knows a client might be interested in certain topics, such as robotics or cannabis.

He adds that the median level of assets in these funds is $37 million. “That’s low,” Johnson says. “[We believe] anything with less than $100 million is [at] risk of potential closure.” Further, it may be difficult for providers “to keep the lights on,” especially as themes fall out of favor.

“People run to where they think they find gold,” he says. “This is a category of funds that appeals to some very basic instinct that many of us have. [But] we would urge people to think twice before buying a shovel and a pickax and heading for the hills.”

Therefore, advisors should do their homework before striking out. “Investors should be cautious, because when these funds liquidate, it could have tax implications for them to the extent that their position in the fund is appreciated,” Johnson says. “There could be costs involved. And certainly the one thing that all investors affected by a fund liquidation will have to do is figure out what they’re going to do with that money.”


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